## The Economics of Money, Banking 11th by Mishkin – Test Bank

*Economics of Money, Banking, and Financial Markets, 11e ***(Mishkin)**

**Chapter 7 The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis**

7.1 Computing the Price of Common Stock

1) A stockholder’s ownership of a company’s stock gives her the right to

- A) vote and be the primary claimant of all cash flows.
- B) vote and be the residual claimant of all cash flows.
- C) manage and assume responsibility for all liabilities.
- D) vote and assume responsibility for all liabilities.

2) Stockholders are residual claimants, meaning that they

- A) have the first priority claim on all of a company’s assets.
- B) are liable for all of a company’s debts.
- C) will never share in a company’s profits.
- D) receive the remaining cash flow after all other claims are paid.

3) Periodic payments of net earnings to shareholders are known as

- A) capital gains.
- B) dividends.
- C) profits.
- D) interest.

4) The value of any investment is found by computing the

- A) present value of all future sales.
- B) present value of all future liabilities.
- C) future value of all future expenses.
- D) present value of all future cash flows.

5) In the one-period valuation model, the value of a share of stock today depends upon

- A) the present value of both the dividends and the expected sales price.
- B) only the present value of the future dividends.
- C) the actual value of the dividends and expected sales price received in one year.
- D) the future value of dividends and the actual sales price.

6) In the one-period valuation model, the current stock price increases if

- A) the expected sales price increases.
- B) the expected sales price falls.
- C) the required return increases.
- D) dividends are cut.

7) In the one-period valuation model, an increase in the required return on investments in equity

- A) increases the expected sales price of a stock.
- B) increases the current price of a stock.
- C) reduces the expected sales price of a stock.
- D) reduces the current price of a stock.

8) In a one-period valuation model, a decrease in the required return on investments in equity causes a(n) ________ in the ________ price of a stock.

- A) increase; current
- B) increase; expected sales
- C) decrease; current
- D) decrease; expected sales

9) Using the one-period valuation model, assuming a year-end dividend of $0.11, an expected sales price of $110, and a required rate of return of 10%, the current price of the stock would be

- A) $110.11.
- B) $121.12.
- C) $100.10.
- D) $100.11

10) Using the one-period valuation model, assuming a year-end dividend of $1.00, an expected sales price of $100, and a required rate of return of 5%, the current price of the stock would be

- A) $110.00.
- B) $101.00.
- C) $100.00.
- D) $96.19.

11) In the generalized dividend model, if the expected sales price is in the distant future

- A) it does not affect the current stock price.
- B) it is more important than dividends in determining the current stock price.
- C) it is equally important with dividends in determining the current stock price.
- D) it is less important than dividends but still affects the current stock price.

12) In the generalized dividend model, a future sales price far in the future does not affect the current stock price because

- A) the present value cannot be computed.
- B) the present value is almost zero.
- C) the sales price does not affect the current price.
- D) the stock may never be sold.

13) In the generalized dividend model, the current stock price is the sum of

- A) the actual value of the future dividend stream.
- B) the present value of the future dividend stream.
- C) the present value of the future dividend stream plus the actual future sales price.
- D) the present value of the future sales price.

14) Using the Gordon growth model, a stock’s current price will increase if

- A) the dividend growth rate increases.
- B) the growth rate of dividends falls.
- C) the required rate of return on equity rises.
- D) the expected sales price rises.

15) Using the Gordon growth model, a stock’s current price decreases when

- A) the dividend growth rate increases.
- B) the required return on equity decreases.
- C) the expected dividend payment increases.
- D) the growth rate of dividends decreases.

16) In the Gordon growth model, a decrease in the required rate of return on equity

- A) increases the current stock price.
- B) increases the future stock price.
- C) reduces the future stock price.
- D) reduces the current stock price.

17) Using the Gordon growth formula, if D1 is $2.00, ke is 12% or 0.12, and g is 10% or 0.10, then the current stock price is

- A) $20.
- B) $50.
- C) $100.
- D) $150.

18) Using the Gordon growth formula, if D1 is $1.00, ke is 10% or 0.10, and g is 5% or 0.05, then the current stock price is

- A) $10.
- B) $20.
- C) $30.
- D) $40.

19) Using the Gordon growth model, if D1 is $.50, ke is 7%, and g is 5%, then the present value of the stock is

- A) $2.50.
- B) $25.
- C) $50.
- D) $46.73.

20) One of the assumptions of the Gordon Growth Model is that dividends will continue growing at ________ rate.

- A) an increasing
- B) a fast
- C) a constant
- D) an escalating

21) In the Gordon Growth Model, the growth rate is assumed to be ________ the required return on equity.

- A) greater than
- B) equal to
- C) less than
- D) proportional to

22) You believe that a corporation’s dividends will grow 5% on average into the foreseeable future. If the company’s last dividend payment was $5 what should be the current price of the stock assuming a 12% required return?

Answer: Use the Gordon Growth Model.

$5(1 + .05)/(.12 – .05) = $75

23) What rights does ownership interest give stockholders?

Answer: Stockholders have the right to vote on issues brought before the stockholders, be the residual claimant, that is, receive a portion of any net earnings of the corporation, and the right to sell the stock.

7.2 How the Market Sets Stock Prices

1) In asset markets, an asset’s price is

- A) set equal to the highest price a seller will accept.
- B) set equal to the highest price a buyer is willing to pay.
- C) set equal to the lowest price a seller is willing to accept.
- D) set by the buyer willing to pay the highest price.

2) Information plays an important role in asset pricing because it allows the buyer to more accurately judge

- A) liquidity.
- B) risk.
- C) capital.
- D) policy.

3) New information that might lead to a decrease in a stock’s price might be

- A) an expected decrease in the level of future dividends.
- B) a decrease in the required rate of return.
- C) an expected increase in the dividend growth rate.
- D) an expected increase in the future sales price.

4) A change in perceived risk of a stock changes

- A) the expected dividend growth rate.
- B) the expected sales price.
- C) the required rate of return.
- D) the current dividend.

5) A stock’s price will fall if there is

- A) a decrease in perceived risk.
- B) an increase in the required rate of return.
- C) an increase in the future sales price.
- D) current dividends are high.

6) A monetary expansion ________ stock prices due to a decrease in the ________ and an increase in the ________, everything else held constant.

- A) reduces; future sales price; expected rate of return
- B) reduces; current dividend; expected rate of return
- C) increases; required rate of return; future sales price
- D) increases; required rate of return; dividend growth rate

7) The global financial crisis lead to a decline in stock prices because

- A) of a lowered expected dividend growth rate.
- B) of a lowered required return on investment in equity.
- C) higher expected future stock prices.
- D) higher current dividends.

8) Increased uncertainty resulting from the global financial crisis ________ the required return on investment in equity.

- A) raised
- B) lowered
- C) had no impact on
- D) decreased

7.3 The Theory of Rational Expectations

1) Economists have focused more attention on the formation of expectations in recent years. This increase in interest can probably best be explained by the recognition that

- A) expectations influence the behavior of participants in the economy and thus have a major impact on economic activity.
- B) expectations influence only a few individuals, have little impact on the overall economy, but can have important effects on a few markets.
- C) expectations influence many individuals, have little impact on the overall economy, but can have distributional effects.
- D) models that ignore expectations have little predictive power, even in the short run.

2) The view that expectations change relatively slowly over time in response to new information is known in economics as

- A) rational expectations.
- B) irrational expectations.
- C) slow-response expectations.
- D) adaptive expectations.

3) If expectations of the future inflation rate are formed solely on the basis of a weighted average of past inflation rates, then economists would say that expectation formation is

- A) irrational.
- B) rational.
- C) adaptive.
- D) reasonable.

4) If expectations are formed adaptively, then people

- A) use more information than just past data on a single variable to form their expectations of that variable.
- B) often change their expectations quickly when faced with new information.
- C) use only the information from past data on a single variable to form their expectations of that variable.
- D) never change their expectations once they have been made.

5) If during the past decade the average rate of monetary growth has been 5% and the average inflation rate has been 5%, everything else held constant, when the Federal Reserve announces that the new rate of monetary growth will be 10%, the adaptive expectation forecast of the inflation rate is

- A) 5%.
- B) between 5 and 10%.
- C) 10%.
- D) more than 10%.

6) The major criticism of the view that expectations are formed adaptively is that

- A) this view ignores that people use more information than just past data to form their expectations.
- B) it is easier to model adaptive expectations than it is to model rational expectations.
- C) adaptive expectations models have no predictive power.
- D) people are irrational and therefore never learn from past mistakes.

7) In rational expectations theory, the term “optimal forecast” is essentially synonymous with

- A) correct forecast.
- B) the correct guess.
- C) the actual outcome.
- D) the best guess.

8) If a forecast is made using all available information, then economists say that the expectation formation is

- A) rational.
- B) irrational.
- C) adaptive.
- D) reasonable.

9) If a forecast made using all available information is NOT perfectly accurate, then it is

- A) still a rational expectation.
- B) not a rational expectation.
- C) an adaptive expectation.
- D) a second-best expectation.

10) If expectations are formed rationally, then individuals

- A) will have a forecast that is 100% accurate all of the time.
- B) change their forecast when faced with new information.
- C) use only the information from past data on a single variable to form their forecast.
- D) have forecast errors that are persistently low.

11) If additional information is not used when forming an optimal forecast because it is not available at that time, then expectations are

- A) obviously formed irrationally.
- B) still considered to be formed rationally.
- C) formed adaptively.
- D) formed equivalently.

12) An expectation may fail to be rational if

- A) relevant information was not available at the time the forecast is made.
- B) relevant information is available but ignored at the time the forecast is made.
- C) information changes after the forecast is made.
- D) information was available to insiders only.

13) According to rational expectations theory, forecast errors of expectations

- A) are more likely to be negative than positive.
- B) are more likely to be positive than negative.
- C) tend to be persistently high or low.
- D) are unpredictable.

14) When using rational expectations, forecast errors will, on average, be ________ and ________ be predicted ahead of time.

- A) positive; can
- B) positive; cannot
- C) negative; can
- D) zero; cannot

15) People have a strong incentive to form rational expectations because

- A) they are guaranteed of success in the stock market.
- B) it is costly not to do so.
- C) it is costly to do so.
- D) everyone wants to be rational.

16) If market participants notice that a variable behaves differently now than in the past, then, according to rational expectations theory, we can expect market participants to

- A) change the way they form expectations about future values of the variable.
- B) begin to make systematic mistakes.
- C) no longer pay close attention to movements in this variable.
- D) give up trying to forecast this variable.

17) According to rational expectations

- A) expectations of inflation are viewed as being an average of past inflation rates.
- B) expectations of inflation are viewed as being an average of expected future inflation rates.
- C) expectations formation indicates that changes in expectations occur slowly over time as past data change.
- D) expectations will not differ from optimal forecasts using all available information.

18) Suppose Barbara looks out in the morning and sees a clear sky so decides that a picnic for lunch is a good idea. Last night the weather forecast included a 100% chance of rain by midday but Barbara did not watch the local news program. Is Barbara’s prediction of good weather at lunch time rational? Why or why not?

7.4 The Efficient Market Hypothesis: Rational Expectations in Financial Markets

1) The theory of rational expectations, when applied to financial markets, is known as

- A) monetarism.
- B) the efficient markets hypothesis.
- C) the theory of strict liability.
- D) the theory of impossibility.

2) According to the efficient markets hypothesis, the current price of a financial security

- A) is the discounted net present value of future interest payments.
- B) is determined by the lowest successful bidder.
- C) fully reflects all available relevant information.
- D) is a result of none of the above.

3) If the optimal forecast of the return on a security exceeds the equilibrium return, then

- A) the market is inefficient.
- B) no unexploited profit opportunities exist.
- C) the market is in equilibrium.
- D) the market is myopic.

4) Another way to state the efficient markets hypothesis is: in an efficient market

- A) unexploited profit opportunities will be quickly eliminated.
- B) unexploited profit opportunities will never exist.
- C) all prices can be accurately predicted.
- D) every financial market participant must be well informed about securities.

5) ________ occurs when market participants observe returns on a security that are larger than what is justified by the characteristics of that security and take action to quickly eliminate the unexploited profit opportunity.

- A) Arbitrage
- B) Mediation
- C) Asset capitalization
- D) Market intercession

6) The efficient markets hypothesis suggests that if an unexploited profit opportunity arises in an efficient market

- A) it will tend to go unnoticed for some time.
- B) it will be quickly eliminated.
- C) financial analysts are your best source of this information.
- D) all profits will be eliminated through taxation.

7) Financial markets quickly eliminate unexploited profit opportunities through changes in

- A) dividend payments.
- B) tax laws.
- C) asset prices.
- D) monetary policy.

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